Based off the enlightening episode of Business by the Numbers, Hunt Demarest, CPA, explores a fascinating tax court case involving a massive $40 million tax bill. This case serves as a backdrop for a broader discussion about just how complex tax liabilities can get, and business strategies for married couples.
The Case Study: Dr. Strom vs. Commissioner
Check out the story of Dr. Strom, whose wife’s stock options led to an unexpected $40 million tax bill. Mrs. Strom, a former executive at InfoSpace, exercised stock options worth $100 million. However, when the stock value crashed, the couple was left with a substantial tax liability on income they never fully realized.
Dr. Strom attempted to invoke the “Innocent Spouse” provision, a tax rule that can relieve a spouse from liability if they were unaware of the tax issues. Unfortunately, the court found that Dr. Strom was aware of the aggressive tax position, and his claim was denied.
Key Lessons for Business Owners
Innocent Spouse Provision:
The Innocent Spouse Provision can really help when you’re facing tax issues because of your spouse’s mistakes on a joint return. But as Hunt explained, proving your innocence is tough. You have to show you had no idea about the income misreporting or fraud. In the case discussed, Dr. Strom tried to use this provision to dodge a $40 million tax bill from his wife’s stock options. The court found he knew about the aggressive tax position, so his claim was denied. This shows the importance of keeping detailed records and being honest with your tax advisor to understand the risks of joint filings.
Stock Options and Taxes:
Exercising stock options can create major tax events, as seen with Mrs. Strom’s $100 million in stock options. Even though the stock value dropped, the tax bill was based on the value when she exercised the options. This situation highlights the need for careful planning. Stock options are taxed as ordinary income when you exercise them, so you could owe taxes even if the stock’s value falls later. Business owners and high earners should work with their tax advisors to plan the best time to exercise stock options and consider selling some options immediately to cover the tax bill.
Spousal Involvement in Business:
Getting both spouses involved in a business can have legal and tax implications. Hunt suggests it might be better to have only one spouse officially on the business paperwork. This can protect personal assets and make tax filings simpler. If the spouse on the paperwork gets into tax trouble, the other spouse’s assets might stay safe. This strategy can also help avoid complications with payroll taxes and employee benefits.
Practical Tax and Business Strategies
Filing Jointly vs. Separately:
Most married couples save money by filing jointly, thanks to better tax brackets and more deductions. But in some cases, filing separately makes sense, especially if one spouse has tax problems or debts. Filing separately can protect the other spouse’s refund and prevent joint liability for mistakes. Hunt advises couples with different income levels or concerns about audits to talk to their tax advisor to find the best filing status.
Payroll Considerations for Spouses:
It might seem like a good idea to pay your spouse for their work in your business, but it’s usually not beneficial unless it’s for retirement contributions. Paying a spouse can lead to extra payroll taxes without providing a big tax deduction. For example, paying your spouse $50,000 in wages won’t reduce your overall taxable income and will increase your tax burden due to payroll taxes. Instead, consider non-taxable ways to involve your spouse in the business or explore retirement contribution strategies to maximize tax benefits.
Protecting Personal Assets:
To manage liability and protect personal assets, consider using legal structures like sole ownership or qualified joint ventures. These can offer liability protection and tax efficiency. For example, owning the business under one spouse’s name can shield the other spouse’s assets from business-related liabilities. In community property states, a qualified joint venture lets spouses co-own a business while getting the tax benefits of a sole proprietorship. Work with legal and tax professionals to set up the best structure for your situation.
By understanding these key lessons and practical strategies, married business owners can better handle tax liabilities and business operations, ensuring financial health for both personal and business affairs.
By understanding these complex issues, married business owners can better navigate their financial and legal landscapes, ensuring both personal and business interests are safeguarded.
Tune in to the full episode here to gain deeper insights and practical advice.
